The EU should not retaliate against Trump’s protectionism

Summary:
If the US moves ahead with Republican plans to introduce a border adjustment tax, the EU will need to decide on its response. Marek Dabrowski argues that the EU would be unwise to retaliate with its own anti-import policies: the border adjustment tax would be difficult to implement and damaging to the global trade order. Instead the EU should build a broad coalition of allies to defend free trade.
Trump’s protectionist challenge
Mark Hallerberg is right to warn that policies from the new US administration may pose ‘…a challenge to the liberal economic order, of which free trade is the most emblematic tenet’. President Donald Trump already withdrew the US from the unratified Trans-Pacific Partnership and threatens to withdraw from NAFTA.
Meanwhile, the Republican majority in the US House of Representatives has advocated the idea of destination based cash flow tax (DBCFT, called also ‘border adjustment tax’ because it would tax imports and exempt exports). This would replace the current corporate income tax. Whether and when such a tax can be approved remains a big question. However, given Trump’s protectionist views on trade and the House Republicans’ push tolower the tax burden on corporate profits, it may happen in the near future.

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If the US moves ahead with Republican plans to introduce a border adjustment tax, the EU will need to decide on its response. Marek Dabrowski argues that the EU would be unwise to retaliate with its own anti-import policies: the border adjustment tax would be difficult to implement and damaging to the global trade order. Instead the EU should build a broad coalition of allies to defend free trade.

Trump’s protectionist challenge

Mark Hallerberg is right to warn that policies from the new US administration may pose ‘…a challenge to the liberal economic order, of which free trade is the most emblematic tenet’. President Donald Trump already withdrew the US from the unratified Trans-Pacific Partnership and threatens to withdraw from NAFTA.

Meanwhile, the Republican majority in the US House of Representatives has advocated the idea of destination based cash flow tax (DBCFT, called also ‘border adjustment tax’ because it would tax imports and exempt exports). This would replace the current corporate income tax. Whether and when such a tax can be approved remains a big question. However, given Trump’s protectionist views on trade and the House Republicans’ push tolower the tax burden on corporate profits, it may happen in the near future.

Such a perspective raises two important questions:

What would the border adjustment tax mean for the world trade system?

What should be the response from the EU?

A hybrid instrument based on incorrect assumptions

The proposed border adjustment tax represents a serious modification of the standard Corporate Income Tax (CIT). First, it would tax enterprise income or value added (profit plus wages) instead of profit. Second, reinvested profits would be taxed at zero rate. Third, imported inputs would not be considered as eligible costs and, therefore, they could not be deducted from the taxable income. Fourth, all exports would be tax exempted. So the border adjustment tax would be a hybrid construction: a combination of direct income tax, indirect value added tax, import surcharge, and indirect export subsidy.

There is no doubt that such a tax would be import-discriminatory and inconsistent with WTO rules. The official justification in the Congressional blueprint says that it ‘…eliminates the existing self-imposed export penalty and import subsidy’. This is factually wrong. There is no such penalty and subsidy in the current US tax system. True, the US does not have a VAT like many other countries in the world (including the EU). But the existing state and local sales taxes are imposed on final consumption regardless of its origin (both domestically produced and imported goods and services) and do not apply to exports. In this respect they do not differ from VAT.

Let me recall that VAT is charged exclusively on final consumption. ‘Border’ VAT on imports and the zero VAT rate on exports are purely technical solutions coming from a multi-stage process of VAT collection. If the ‘border’ VAT is charged on intermediary or investment goods it is deducted from the VAT bill paid in the next stages of production/distribution. If it is charged on consumer goods it is passed on consumer, similarly to a US consumer who pays sales tax. Zero rate for exports means returning VAT paid in previous stages of production/distribution. US exporters do not need such a return because their inputs do not include VAT from previous stages of production.

History lessons: avoid a trade war

Let us assume that a border adjustment tax in the form proposed in the Congressional blueprint will be adopted at some point. How should the EU react to this decision? Mark Hallerberg suggests that it should consider doing the same. I believe this would be a major policy mistake.

Any sort of retaliation would mean starting a global trade war, clearly a lose-lose game for everyone. One should remember the lessons of the Great Depression: in response to the Smoot-Hawley Tariff Act adopted by the US Congress in 1930 (which raised US tariffs on over 20,000 imported goods) other countries retaliated (including Canada, Britain, France and Germany). A combined effect of the crisis related deflation, recession and trade war (these factors reinforced each other) led to decline of global trade by approximately 70% between 1929 and 1933 Rebuilding this damage took several decades.

The EU’s dependence on trade with the rest of the world is similar to that of the US (approximately 30% of GDP). Thus, damage to EU growth from retaliatory trade measures would be similar to that of the US (both are difficult to estimate but, most probably, would be substantial). In addition, having a trade surplus with the rest of the world (unlike the US, which runs trade deficit) the EU could not expect fiscal gains from introduction of the DBCFT.

Existential threat to the global trade order

If the EU adopts the border adjustment tax or any other retaliatory trade measure in response to US protectionist steps, it would mean the end of the WTO and associated system of global trade agreements such as the GATT and GATS. Perhaps the WTO can survive a period of US protectionism (although eve this is not sure) but it will certainly not survive if such policies are copied, for whatever reason, by the EU – the largest global trade player.

Furthermore, for the EU to adopt the border adjustment tax would undermine its own system of free trade agreements (FTAs). The EU has deals with more than 50 countries and territories around the world, including EFTA countries, EU candidates, the EU’s Eastern and Southern neighbours, dependent territories of EU member states (like Greenland), and such big players as Canada, South Korea, and Mexico. Adding special clauses to those agreements in order to consider trade with privileged partners as ‘domestic’ for tax purposes (as suggested by Hallerberg) would take years and create a political and legal nightmare.

Another of Mark Hallerberg’s suggestion, that such a tax could bring benefits in the forthcoming Brexit negotiations, also sounds problematic. In my opinion, it would only make the Brexit negotiations more confrontational. It is in the common economic and geopolitical interest of the EU27 and UK to find maximally cooperative free trade arrangements in the post-Brexit era, as suggested by the Bruegel paper on Continental Partnership.

Incompatibility with the EU tax system

Adopting the border adjustment tax within the EU would be hardly compatible with the existing tax system (most probably, the same applies to the US but this question remains beyond the scope of this analysis). We can assume that an EU border adjustment tax would replace, similarly to the US blueprint, the existing corporate income taxes (CIT). This would mean an further shift from direct taxation towards a sort of indirect taxation (although still retaining some characteristics of the former), in a conext where the EU already makes much greater of indirect taxation compared to the US.

It is true that CIT may include disincentives to undertake greater entrepreneurial effort and artificially inflate costs, but this is not so big issue in EU member states where CIT rates are generally low. On the other hand, unlike in the case of indirect taxation, it may target some highly profitable activities providing an additional source of government revenues.

The border adjustment tax would also duplicate, to some degree, the existing VAT but in much less perfect and more distortive way (because of its trade protectionist bias). The question is what would be the potential economic benefit of such duplication?

Most importantly, however, tax policy is largely a competence of EU member states, especially in respect to direct taxation (except a certain degree of harmonisation of VAT and excise tax rules and rates). The proposed construction and purpose of the border adjustment tax (taxing imports and subsidising exports) would suggest rationale of its collection on the EU level rather than national level (otherwise it would undermine the common external trade policy). However, introducing any EU federal tax would require far-going changes in the existing Treaties, the task hardly affordable in a near future.

The EU should defend the global free trade order

Retaliation is often politically tempting but rarely justified in case of trade policy conflicts. Unilateral protectionist measures of the sort considered by Trump’s administration will be damaging enough to the US economy that there is no need for the EU to punish the US (and itself) additionally through retaliatory trade measures.

Obviously the EU may challenge US policies via the WTO dispute settlement mechanism. However, much more important is its active leadership in defending the global economic and trade order. This will require building a pro-trade coalition with other important economic players such as China, Japan, India, Canada, Australia, and other advanced and emerging market economies. The EU should speed up its free trade negotiations with Japan and India, upgrade existing FTAs with Latin American and Asian countries, and offer a FTA to China. Such initiatives would benefit both the EU economy and its partners, while creating trade diversion effects against the protectionist US.

In order to advance successfully on such an agenda, the EU27 must return to a greater internal unity on trade issues. This unity was undermined by the recent conflict around the Comprehensive Economic and Trade Agreement with Canada.) Furthermore, internal unity will be helpful in attempts to persuade the new US administration to abandon its protectionist and confrontational proposals.

Dr. Marek Dabrowski is a Non-Resident Scholar at Bruegel, Professor at the Higher School of Economics in Moscow, co-founder and Fellow at CASE - Center for Social and Economic Research in Warsaw and Member of the Scientific Council of the E.T. Gaidar Institute for Economic Policy in Moscow.